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Monetary policy in a small open economy with a preference for robustness

  • Richard Dennis
  • Kai Leitemo
  • Ulf Söderström

We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2007-04.

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Date of creation: 2007
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Handle: RePEc:fip:fedfwp:2007-04
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  14. McCallum, Bennett T. & Nelson, Edward, 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Seminar Papers 644, Stockholm University, Institute for International Economic Studies.
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  25. Richard Dennis, 2004. "Specifying and estimating New Keynesian models with instrument rules and optimal monetary policies," Working Paper Series 2004-17, Federal Reserve Bank of San Francisco.
  26. Kirdan Lees, 2006. "What do robust policies look like for open economy inflation targeters?," Reserve Bank of New Zealand Discussion Paper Series DP2006/08, Reserve Bank of New Zealand.
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  30. Jeffrey C. Fuhrer, 1995. "The [un]importance of forward-looking behavior in price specifications," Working Papers 95-6, Federal Reserve Bank of Boston.
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